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By Paul Justice, CFA | 09-01-2010 11:04 AM

What Is Exotic Beta?

Russell Investments CIO Erik Ristuben comments on the use of factor exposures in portfolios.

Paul Justice: I'm Paul Justice, director of North American ETF research, coming to you live from the ETF Invest Conference in Chicago. I am joined by Erik Ristuben. He is the Chief Investment Officer, Client Strategies, at Russell Investments.

Erik, thank you for joining me.

Erik Ristuben: Thanks for having me.

Justice: We've heard some pretty complex terms that have been thrown around at this conference, and one of those is "Exotic Beta." It sounds almost borderline like a swear word. But could you give me your impression of what that really means?

Ristuben: I think it does mean different things to different people. The way I interpret it is that if you think about how managers actually function – so if you look at broad manager populations, and we spend a lot of time at Russell looking at managers, it's one of the things that we've done a long time and we think we're quite good at it – you realize that a lot of their performance, yes, security selection, a big component of their incremental return, but they also have factor exposures and consistently have populations of factor exposures. Maybe certain types of managers, earnings momentum managers, obviously, have a high momentum aspect built into their strategy.

"Exotic beta" really is thinking about that classic statement in the industry, which is a lot of alpha is just misspecified beta. That's really what it is. It's really saying, okay, what am I getting from a manager in terms of security selection and how much of it is coming from the factors? And then I think the second question becomes, how comfortable am I right now potentially with those factors, right? How comfortable am I with high momentum in my portfolio? Is that something I want to amplify? Is that something that I want to take down?

I think that beta – I mean, do I want more beta, do I want less beta, right now? Do I want to hire and fire a manager or do I want to do that by either going a long or shorting an ETF? I think a lot of people are going to choose to long or short the ETF.

Justice: And do I want to pay an active manager a high fee if he is only giving me some form of beta or do I want to really focus on the managers who are out-producing in that area, if I go that route?

Now, you are saying that in exotic beta there are many factors that play into the equation right now. Do you think that there are any ones that are more prevalent today or do you think that that's something beyond the scope of financial advisors to really do on their own--they could really use the help of an institutional backing or a product?

Ristuben: I think they are going to need help. Because the exposures that you are looking at, you have to understand what are the common exposures populations of managers have. I mean, you use your nine box, right?

Justice: Sure.

Ristuben: You're nine-style box. Each of those boxes managers have a very specific set of factor or characteristics--factor exposure or characteristics, and understanding what those are and understanding the ones that are driving performance at different times, say, in the market cycle or at different points in the overall portfolio, and how those patterns are likely to play out over time in different scenarios, you really need that understanding if you are going to construct either an index or some type of product that is going to be meant to either amplify or reduce those exposures of those populations.

I'm not sure that – I think lot people like Russell, I think Morningstar, we have a lot of experience in looking at managers. I think we're going to have to help.

Justice: I agree with that statement wholeheartedly, but I appreciate your insights into what exotic beta is and how it can potentially be used.

Again, thank you for joining us, and thank you for joining us at the ETF Conference. I am Paul Justice from Morningstar, joined by Erik Ristuben of Russell Investments.

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